Chapter 01 – Introduction to Corporate Finance
Chapter 1 Introduction to Corporate Finance
OVERVIEW
The opening chapter provides the students with an overview of the field of finance and a brief overview
of the book. The chapter briefly explains the role of corporations, financial managers and financial
markets in the financial decision making process. The success of any firm in financial management is
measured by the increase in the increase in the value of the firm. The financial decisions made by firms
are generally geared towards this objective. Generally, there are two types of financial decisions that are
made in a corporation: investment decisions and financing decisions. In order to make these decisions a
financial manager not only uses input from the corporation, but also from financial markets. Related
topics, such as different types of corporations, the role of the financial manager, and the importance of
well-functioning financial markets in the financial decision making process, are discussed.
LEARNING OBJECTIVES




Understand the definition of a corporation and how finance fits into the corporate structure.
The role of the financial manager in a corporation.
Functions of financial markets.
Principal-agent problems, agency costs and information asymmetries.
CHAPTER OUTLINE
Corporate investment and financing decisions
The primary components of the entire book are presented. These include investment and financing
decisions. Both are presented under the umbrella the corporation. It is important to emphasize that these
two concepts are driving the book. That message can be lost and must be reinforced from the beginning.
The emphasis on the corporation is also important, since students sometimes deviate into business
structures that are not necessarily the core focus of the book.
The role of the financial manager and the opportunity cost of capital
The financial manager is pictured as an intermediary between capital markets and the firm’s operations,
responsible both for financing decisions (decisions that involve raising money) and investment decisions
(decisions that involve spending money). The financial manager must understand how risky, long-lived
assets are valued in order to make decisions that benefit the shareholders/owners. They also must
understand the functions of financial markets. Financial markets provide a source of financing for
corporations. Financial markets provide liquidity for investors by providing a place to trade securities.
An important emphasis in this section is the opportunity cost of capital. Students often know of this
phrase from an economics course, but rarely understand the component of risk that is attached to
opportunity cost. This is the place where an emphasis on risk return trade-offs should begin.
1-1
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 01 – Introduction to Corporate Finance
Goals of the corporation
Value maximization is presented as a traditional concept. It is immediately modified to incorporate
modern thought on the topic. This expands the goal from simply value maximization to include other
components, such as ethics and stakeholders. The section does not attempt to define the goal of the
corporation as etched in stone. Given the graduate nature of the text, the topic is presented in a Socratic
method and the student is left to ponder the issues raised by ethics, stakeholders and other issues which
impact value creation.
Agency problems and corporate governance
The separation of ownership and management is an important characteristic of the corporation. In the
ideal case, this enables the managers to make decisions without worrying about owners’ preferences. It
has its share of advantages and disadvantages. This gives rise to principal-agent problems and agency
costs. These concepts are discussed in this section. Information asymmetries are major barriers to
resolving principal-agent problems facing corporations. The topic of corporate governance is introduced
and should be supplemented by current events. The mortgage crisis is noted as one such example.
Topics covered in this book
An overview of the topics covered in the book is provided.
TEACHING TIPS FOR POWER POINT SLIDES
Slide 1 - Title slide
Slide 2
This slide is merely an overview of the upcoming topics. There is no need to spend too much time here,
other than to explain that each of these topics are related to the bigger picture of investments and
financing. The relationship to investments and financing should be restated many times during the chapter
and even the entire course.
Try to cite examples of both real and financial assets. It is often a good idea to identify a student who
likes to participate and ask them what kind of business they want to start. Use the student’s business idea
to create actual examples. If, for example, the student wants to start a pie baking business you can use the
oven, building, and other equipment as real assets. Assume the student raised money via a loan from a
bank and an equity investment from family members. These can be cited as financial assets.
Slide 3
Continue the example provided in the previous slide and begin to identify the relationship between
investment and financing decisions. Using the pie baking example, or whichever one you develop in
1-2
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 01 – Introduction to Corporate Finance
class, to draw the students into the world of financing terminology by connecting the dots between the
steps in starting the pie business and the theoretical concepts in finance.
Slide 4
This is where you begin the process of introducing more abstract concepts and formal terminology.
CAPEX is a first step in showing the students terms commonly used in the profession. This moves the
students away from the big picture of investments and into the more specific finance phrase of capital
budgeting.
If the example presented is too abstract for the students, return to the example used earlier. As with a pie
baking company, point out the difference between investing in more ovens versus something abstract like
the expanse of experimenting with a new recipe or expanding your business by purchasing a brand name
pie company
Slide 5
This table is taken directly from the book and shows examples of investment and financing decisions. It is
highly encouraged to take examples for the current news and add them as topics of discussion in class.
Students related much better when they can reference an event for which they are familiar.
Slide 6
This slide explains corporations and the concept of limited liability. Most students will already be familiar
with these concepts.
Slide 7
Explain the critical role of the financial manager in obtaining funds from financial markets to fulfill the
needs of the firm. Be certain to provide the big picture. Explain the cash flows shown in the slide.
Explain how cash is generated from operations. Explain how this slide helps in understanding the role of
the financial manager. The financial manager must learn to value real and financial assets. The financial
manager must understand how financial markets work, for it is there that value is ultimately determined.
Also explain the cash flow cycle as given in the diagram.
Slide 8
Begin this section with a review of the traditional role of the firm in maximizing the value of
stockholders. Spend time pointing out the role and rights of owners of a company to have their goals
achieved. It is important to make sure students know the link between ownership of the company and the
legitimate desire to maximize stock price.
Slide 9
Leap from the concept of maximizing stock price to the concept of how it is done. Point out that the
natural tendency to achieve high profits may not necessarily accomplish this task. Long term versus short
term profits can be introduced and maybe even a discussion of the short term mindset of the capital
markets.
1-3
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 01 – Introduction to Corporate Finance
Slide 10
An excellent follow up to the debate between shareholders and stakeholders is the debate between
shareholders and managers. Here it is worth noting the source of true power. In fact, it is important to
highlight the fact that owners of a public corporation have very little power relative to managers.
Examples of state corporate law can be presented to show the limited influence shareholders have over
managers.
Slide 11
Here is an important concept check. While not much is written on this slide, take time to draw out the
student’s understanding of opportunity cost from their economics course. Some will refer to it as what an
investor gives up. Alert students will define it as the value of the next best alternative. Take that definition
and explain to them that in the world of finance we add a vital few words, “…at the same level of risk.” If
you have an example of how companies you know use different hurdle rates, or examples where
companies improperly only use one rate for every decision, cite these as dos and don’ts.
Slide 12
Taken directly from the book, emphasize the decision managers must make. This shows the flow of cash
as determined by the financial manager. Continue to point out that this is a capital budgeting or
investment decision. That theme was introduced earlier and should be constantly reinforced.
Slide 13
This slide is more of a summary slide to bring the prior discussion back into focus. It is easy to get
distracted with details. This is chance to remind everyone the issue being discussed and the core topic of
stakeholders.
Slide 14
Explain the concept of separation of ownership and management. Discuss advantages and disadvantages
this has, the potential for conflict of interests between shareholders and managers. Explain agency costs,
principal-agent problems and information asymmetries.
Slide 15
Not only do managers not necessarily respond to the needs of shareholders, the owners incur costs related
to protecting their interests. Plenty of current news stories exist to illustrate this point.
Slide 16
Now we begin talking about how to force mangers to focus on value creation. We can begin with some
theoretical concepts and go over why the managers are not always looking out for th interest of the
shareholders. Review the financial incentives that exist.
1-4
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 01 – Introduction to Corporate Finance
KEY TERMS AND CONCEPTS
Investment, financing, corporations, limited liability, board of directors, separation of ownership and
management, chief financial officer (CFO), treasurer, controller, principal-agent problems, agency costs,
information asymmetry, opportunity cost, stakeholder, shareholder, real assets, intangible assets,
governance.
CHALLENGE AREAS




Financing and Investing
Corporate governance
Agency costs
Opportunity cost
ADDITIONAL REFERENCES
Allen, Franklin, James McAndrews, and Philip Strahan. “E-Finance: An Introduction” Working Paper 0136, Financial Institutions Center, The Wharton School, University of Pennsylvania. October 2001.
Core, J.E., W.R. Guay, and D.F. Larcker. “Executive Equity Compensation and Incentives: A Survey,”
Federal Reserve Bank of New York Economic Policy Review, 9 (April 2003), pp. 27-50.
Gompers, P.A., J.L. Ishii, and A. Metrick. “Corporate Governance and Equity Prices” Quarterly Journal
of Economics, 118(1), February 2003, pp. 107-155.
L. Guiso, L. Zingales, and P. Sapienza, “Trusting the Stock Market,” Journal of Finance 63 (December
2008), pp. 2557–600.
Mackie-Mason, J.K., and R.H. Gordon. “How Much Do Taxes Discourage Incorporation?” Journal of
Finance, (June 1997).
Rappaport, A. “New thinking on how to link executive pay with performance.” Harvard Business
Review, March-April 1999, 91-104.
WEB LINKS
www.mcgraw-hill.co.uk/textbooks/brealey
www.corpgov.net
www.thecorporatelibrary.com
www.riskmetrics.com
www.microsoft.com
www.sony.net
www.nestle.com
www.ge.com
www.ft.com
www.economist.com
www.businessweek.com
1-5
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 01 – Introduction to Corporate Finance
www.forbes.com
www.fortune.com/fortune
www.cfo.com
ADDITIONAL INTERNET ACTIVITIES
Visit
http://finance.wharton.upenn.edu/~allenf/download/Vita/e-finance.pdf
Read the article “E-Finance: An Introduction.”
1-6
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.